The Role of Disclosure in the Unregulated Crypto Market

Our new research paper studies the issuers of unregulated crypto-tokens such as EOS and Tether. We examine two dimensions: the success of the Initial Coin Offering (ICO) process, and the capital market patterns following the listing of the tokens on exchanges. Specifically, we study how these issuers signal their quality to investors, and how their disclosure practices affect market quality.

Crypto-tokens are different from crypto-currencies such as Bitcoin, which serve as a medium of exchange like fiat currencies. Instead, crypto-tokens are sold by “virtual organizations” that want to raise capital for their projects through initial coin offerings (ICOs), which are similar to other capital raising mechanisms, including equity crowdfundings and initial public offerings on stock exchanges. After the ICO, the crypto-token trades on crypto exchanges such as Kraken, Binance, and Bitfinex. The most popular platforms on which crypto-tokens are based are Ethereum and NEO, because they enable “smart contracts.”

The unregulated market for crypto-tokens has grown exponentially, allowing issuers to raise more than $13 billion so far. This naturally prompts questions about investor protection and market quality, especially given that both retail and institutional investors of varying degrees of sophistication trade on crypto exchanges. This growth has prompted the Securities and Exchange Commission and other securities regulators to scrutinize this market and contemplate potential regulation. The key issue in the United States is whether these tokens are viewed as investment contracts by the SEC based on the U.S. Supreme Court’s ruling in SEC v. W.J. Howey Co. in 1946 (the “Howey Test”), and hence would need to be regulated as securities. To date, no specific regulation has been put in place in the United States.

We analyzed a global sample of more than 750 ICOs that occurred from April 2014 to May 2018. Our primary findings:

Issuers of tokens try to signal their quality to investors through informative disclosure documents, called whitepapers, by making their technical source code available for public review, and through various social media.

Successfully raising funds is more likely when the issuer produces a high-quality whitepaper, discloses technical source code, and has a strong information environment, such as an active social media presence and a high score from ICO rating providers.

Issuers with a weaker information environment experience higher illiquidity and return volatility after the ICO.

The prices of some tokens crash 75 percent or more within a few months after their ICOs, and these ICOs tend to have lower quality disclosure and a weaker information environment, which suggests that some issuers strategically time their capital raising for when markets are “hot” and engage in “pump and dump” schemes that harm investors.

There is significant underpricing in the ICO market—the median ICO return (from ICO offer price to the closing price on the first day of trading) is 49 percent. However, over the 30 days after the ICO, these returns dissipate quickly, pointing to the role that hype and investor attention play in this market.

Our results point to the positive role of information and disclosure in enabling investors to distinguish among ICOs on the basis of quality. Also, our results indicate that investors can benefit from new information intermediaries, such as ICO rating providers, that have evolved in this unregulated market to provide monitoring and assessment of the quality of tokens. As such, these rating providers may serve to increase trust in the information disclosed by the issuers.

This post comes to us from professors Thomas Bourveau at Columbia Business School, Emmanuel De George at London Business School, and Atif Ellahie and Daniele Macciocchi at the University of Utah. It is based on their recent paper, “Initial Coin Offerings: Early Evidence on the Role of Disclosure in the Unregulated Crypto Market,” available here.